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When is a payment arrangement treated as disguised compensation?

The proposed Department of Treasury regulations (REG-115452-14) under IRC section 707(a)(2)(A) set forth standards to determine when a payment arrangement to a partner shall be treated as disguised compensation. Section 707(a) generally governs payments to partners who render services to a partnership other than in a partner capacity. Additionally, the rules will affect standards under section 704(b) to reflect the principle that a payment must be subject to significant entrepreneurial risk in order to be considered a distributive share. Section 704(b) most importantly provides for pass-through treatment of capital gains and other tax-favored items from the partnership to its partners. As a result of the foregoing, the rules include changes to the scope of section 707(c) governing guaranteed payments. The rules would become effective on the date the final regulations are published.

These rules, if finalized, will have a significant effect upon the issuance of interests in private equity (PE) funds and the structure of distributive shares for its general partners and principals. In particular, these rules affect fee waiver arrangements, but also create general uncertainty as to how to treat partners that are receiving payments from a partnership that one otherwise thought would constitute a distributive share. A summary of the effect of these rules on PE funds can be found towards the end of this article.

Alternative tax characterizations

Income that a partner receives from a partnership in exchange for services can be characterized in one of three ways: a distributive share under section 704(b); a guaranteed payment under section 707(c); or a section 707(a) payment for services rendered in a nonpartnership capacity, often referred to as “disguised services” income. Allocations made to a partner providing services in a partner capacity where the allocation depends on partnership income is generally a distributive share under section 704(b). The two alternative characterizations under section 707 address arrangements in which either a service partner receives income in the capacity of a partner, but without regard to partnership income (section 707(c)) or engages with a partnership in the capacity of a non-partner (section 707(a)). Tax treatment varies across each category for the service partner as well as for the partnership.

For instance, a distributive share of partnership income under section 704(b), is taxed under the general rules in sections 702, 703 and 704, and benefits from flow-through tax characterization. A distributive share may also qualify as a “profits interest” for the purpose of Rev. Proc. 93-27, which provides safe harbor protection from immediate income inclusion upon receipt.

On the other hand, a partner is taxed on a payment under section 707(a) or (c) as if the payment were made to someone other than a partner for some or all purposes of the Code. If a payment is treated as a guaranteed payment under section 707(c), that is, a payment to a service provider in a partner capacity, but without regard to partnership income, it is considered as having been made to a non-partner under sections 61 and 162(a). Often, this results in the payment being treated as ordinary income for the purposes of those sections. A service partner who receives a section 707(a) payment is treated as having received ordinary services income for all purposes of the Code. In either case, the service partner does not receive the benefits of flow-through characterization as it would in the case of a distributive share.

Disguised payment for services

Section 707(a)(2)(A) is an anti-abuse rule under 707(a) and provides that if a partner performs services for a partnership and receives a related direct or indirect allocation and distribution, and the performance of services, together with the allocation and distribution, are properly characterized as a transaction between the partnership and the partner in a non-partner capacity, the transaction will be governed by section 707(a).

Fee waiver arrangements

In a typical fee waiver arrangement, a fund manager or the management company waives some or all of its management fee (generally two percent) that would have been taxable as ordinary income. In lieu of the fee, the fund manager, usually the GP of the fund, receives an interest in the fund’s future income, sometimes in the form of a “special allocation,” which usually takes priority over an ordinary interest in profits. Generally, managers take the position that the income received in this arrangement represents a distributive share of partnership income entitled to flow-through tax characterization. Since PE funds often hold portfolio investments for periods of seven to 10 years, much of the character flowing through would be long-term capital gain.

Even prior to the proposed rules, it was possible for the Internal Revenue Service (IRS) to argue that certain PE fee waiver arrangements were disguised payments for services. The legislative history identified certain factors to consider, the most important being whether an allocation bore “significant entrepreneurial risk.” An arrangement in which an allocation and distribution to a service partner is subject to significant entrepreneurial risk as to the amount is generally recognized as a distributive share—this remains true under the proposed rules. Various other factors are also relevant, but secondary.

Proposed rules: multi-factor test

The proposed rules, borrowing heavily from the factors outlined in the legislative history, call for a multi-factor analysis to identify payments under section 707(a). The payment arrangement is tested under these rules at the time at which the parties enter into or modify the arrangement. The primary and weightiest factor is whether, as a result of this alternative payment structure, the general partner has taken on “significant entrepreneurial risk.” Under the proposed regulations, arrangements that lack significant entrepreneurial risk will be treated as disguised payments for services regardless of the other factors.

The following characteristics create a presumption that there is a lack of significant entrepreneurial risk:

Capped allocations of partnership income (if the cap is reasonably expected to apply in most years)

An allocation for one or more years where the service provider’s share of income is reasonably certain

An allocation of gross income to the service provider

An allocation that is predominately fixed in amount, reasonably determinable under all facts and circumstances, or designed to assure sufficient net profits are highly likely to be available to make the allocation (e.g., because the agreement only allocates net profits from certain periods or transactions and does not depend on the long-term success of the enterprise)

An arrangement in which a service provider waives its right to receive payment for future performance of services in a manner that is non-binding, or fails to notify the partnership and its partners of the waiver and its terms in a timely manner

The preamble clarifies that catch-up allocations to a service partner generally do not fall under the fourth category. However, priority allocations to a service partner that are measured over an accounting period of one year or less, together with an ability for the service partner (or related party) to control either the determination of asset values in the case of hard-to-value assets, or the entities in which the partnership invests—including the amount and timing of distributions by such entities—create a higher likelihood that net profits will be available for the allocation. The examples further illustrate that a failure to measure profits over the life of the partnership would cause one to examine whether the allocation is a fee for services.

Basically, only waiver arrangements which involve a fund manager taking on significant entrepreneurial risk will be rewarded with the attendant benefits of a distributive share, namely flow-through characterization. Alternatively, in cases where the terms of the purported allocation as a result of the waiver arrangement indicate that the manager is highly likely to receive income regardless of the success of the business, the rules treat the profits interest as disguised compensation under 707(a).

In additional to “significant entrepreneurial risk,” there are five secondary factors that must be considered. The weight given to each of these factors depends on the facts and circumstances of each case. The secondary factors that may characterize an arrangement as a payment for services include the following:

Service provider holds a partnership interest for only a short duration

Service provider receives an allocation and distribution in a time frame comparable to when a non-partner service provider would typically receive payment

Service provider became a partner primarily to obtain tax benefits which would not have been otherwise available

The value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution

An arrangement provides for (i) different allocations or distributions with respect to different services received; (ii) the different services are provided either by a single person or related persons; and (iii) the entrepreneurial risk associated with the different allocations and distributions varies significantly

Elimination of safe harbor protection

Rev. Proc. 93-27 defers taxation upon the receipt of a profits interest for the provision of services to a partnership in a partner capacity. However, the revenue procedure makes clear that the safe harbor does not apply where there is a “substantially certain and predictable stream of income” from partnership assets, or in cases where the interest is disposed of within two years of receipt. If an allocation is not treated as a distributive share, or is excluded from the administrative safe harbor under either of these exceptions, this raises questions of how to tax the interest, and whether the IRS can argue that the service partner must currently include income upon receipt of the purported profits interest.

The IRS has indicated that this administrative safe harbor does not apply to cases where one party provides services and another party is allocated partnership income in association with the provision of those services. This describes the organization of most funds in New York (driven by the local tax law), where the management company is a separate entity (non-partner), delegated management responsibility by the GP via contract. As a result, in addition to arguing that ordinary income treatment applies to such arrangements under section 707(a), the IRS will be able to argue that a profits interest received pursuant to this type of fee waiver arrangement is currently taxable upon receipt. Consistent with this view, Treasury and the IRS plan to issue an additional exception to the profits interest safe harbor for fee waiver arrangements.

Effect on PE funds

The following is a summary of the effect of these rules on partnership arrangements in the context of PE funds.

Whether an arrangement lacks significant entrepreneurial risk is relative to the overall entrepreneurial risk of the partnership with respect to its own activities. For example, entrepreneurial risk can exist with respect to participation in a venture capital fund as well as a fixed income fund.

Partnership allocations, including carried interests determined with respect to a subgroup of assets, may not qualify as a distributive share. The argument would be the same as the reasons for denying favorable tax treatment for an allocation of profits out of a particular tax period—that is, because there is a risk that the allocation could be limited to a subgroup of assets that is expected to be profitable.

Allocations of future income should include a clawback provision in order to be considered a distributive share. A “clawback obligation” is described as an enforceable obligation to repay any amounts distributed pursuant to a profits interest that exceed the partner’s allocable share as computed over the life of the partnership, where it is reasonable to anticipate that the general partner can and will comply fully with this obligation. These rules appear to say that significant entrepreneurial risk requires that an allocation be a percentage of net profits over the life of a partnership with respect to all assets of the partnership. In order to achieve this, there would have to be some type of accounting at the end of the relevant period and a possible adjustment pursuant to a clawback obligation.

Section 707(a) has been a looming threat to fee waiver arrangements long before this notice, especially those involving elective quarterly or monthly waivers, where at the time of the election, the fund manager may already have a sense of how profitable the fund will be in the following quarter. The rules appear to draw a line in the sand, permitting only fee waivers that are elected prior to the beginning of the service period, and not in cases where there has been, in effect, constructive receipt. Further, the proposed regulations and the examples applicable to fee waivers appear to support the existence of significant entrepreneurial risk where there is an:

Allocation out of net profits (not limited to a particular transaction or accounting period) that is not reasonably determinable or highly likely to be available at the time of the waiver, and service provider undertakes a binding clawback obligation (see Example 5)

Execution of a legally binding and irrevocable waiver, clearly communicated to the other partners well in advance (60 days or more) of the services period under the management fee agreement (see Example 6)

Other consequences

First, the proposed regulations do not address timing issues for service payments governed by sections 707(a) (2)(A) and 1.707-2. The issue of when a payment for services should be included in the income of the service provider and when the partnership can take a deduction is determined under existing law.

Next, the preamble to the proposed regulations indicates that an arrangement that is treated as a disguised payment for services under these proposed regulations will be treated as payment for services for all purposes of the Code. It is necessary to consider whether a service partner receiving a payment governed by section 707(a)(2)(A) constitutes an employee or independent contractors.

Finally, the preamble also indicates that if an allocation is re-characterized under section 707(a) as a payment for services, the deferred compensation rules under section 409A and 457A may apply. For example, if the fund manager has “received” income for the purposes of section 409A, that section imposes immediate taxation on any deferred income, assuming no exception applies.

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